The Impact of Financial Leverage to Profitability Study of Vehicle Companies From Pakistan (2)(1) (1)

7/28/2019 The Impact of Financial Leverage to Profitability Study of Vehicle Companies From Pakistan (2)(1) (1)

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Chapter 1

INTRODUCTION

1.1 Background of the Study

The study is conducted to know the effect of financial leverage on profitability of vehicle companies

registered in stock market will see whether financial leverage effect the profitability positively or

negatively.

It is that kind of money which the firm borrowed so they will invest it in the firm to increase their

profit. Financial leverage lower the amount borrowed so lower will be the profit and also we will pay

lower interest on it.

Financial leverage is lower the amount borrowed so greater will be the profit and they will also pay

lower interest on it. Firm always pay a fixed % of interest on it also show the level of risk so its all

depend on firm management decision that how they will used it. It can also increase when EPS is in

favorable condition also it is unfavorable when economic condition is not good due to financial

depression due to this some of the firm will insolvent because of they are not earning that level of

profit because of financial leverage the wealth of shareholder will also increase.

Financial leverage reflects the debt amount used in the capital structure of the firm. Financial

leverage is an impact on returns of a change in the extent to which the firms assets are financed with

borrowed money. Other things remaining same, lower the amount borrowed, lower the interest,

lower will be the profit, whereas greater the amount borrowed, lower the interest, greater will be the

profit. Debt carries a fixed service obligation of payments of interest. There is an opportunity to

greatly magnify the results at various levels of business operations by using financial leverage


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Financial leverage measures firms exposure to the financial risk. So, degree of financial leverage

indicates the percentage change in EPS resulting from a unit percentage change in EBIT. Financial

leverage can accelerate EPS under favorable economic conditions but depresses EPS when the

economic goings is not good at economy and for the firm. The unfavorable effect of financial

leverage on EPS is more severe with more debt in the capital structure when EBIT is negative.

Similarly, financial leverage can increase shareholders return and as well can increase the firms

risk also. The financial leverage employed by a firm is intended to earn more on the fixed charges

funds than their relative costs (Pandey, 2007).

Financial leverage is the final component of return on equity. Financial leverage is a measure of how

much firm uses equity and debt to finance its assets. As debt increases, financial leverage increases.

Management tends to prefer equity financing over debt since it carries less risk.

The Financial leverage ratio is calculated by dividing assets by shareholder equity (Matt, 2000).

When the surplus increases and deficit decreases, the return on the owners equity, referred to as

a double-edged sword, financial leverage provides the potentials of increasing the shareholders

wealth as well as creating the risks of loss to them. The financial leverage is a prerequisite for

achieving optimal capital structure. An optimal capital structure can influence the value of firm and

wealth of shareholders through reduced cost of capital. Hence, determination of optimal debt level

and its impact on the firms over all capital structure is regarded as an integral part of a firms

financial decision (Franklin and Muthusamy, 2011). Financial leverage, or an increase in financial

efficiency, called the variation of return on equity, depends on the return on assets and the cost of

credit i.e., interest rate. Financial lever also expresses the impact of financial expenses due to loans

on the return on equity of an enterprise (Brezeanu, 1999).


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The Debt-to-equity ratio (debt/equity ratio, D/E) is a financial ratio indicating the relative proportion

of entity's equity and debt used to finance an entity's assets. This ratio is also known as financial.

Debt-to-equity ratio is the key financial ratio and is used as a standard for judging a company's

financial standing. It is also a measure of a company's ability to repay its obligations. When

examining the health of a company, it is critical to pay attention to the debt/equity ratio. If the ratio

is increasing, the company is being financed by creditors rather than from its own financial sources

which may be a dangerous trend. Lenders and investors usually prefer low debt-to-equity ratios

because their interests are better protected in the event of a business decline. Thus, companies with

high debt-to-equity ratios may not be able to attract additional lending capital.

Calculation (formula)

A debt-to-equity ratio is calculated by taking the total liabilities and dividing it by the shareholders'

equity:

Debt-to-equity ratio = Liabilities / Equity

Profit is defined as the excess of the amount of sales and other income after deducted by all costs.

Profit is the term used as the net income performed by the company. Profit can be classified into

several categories such as Sales or revenues used to show the income gained before it is subtracted

by costs, Earnings before interest, tax, depreciation, and amortization (EBITDA) which shows the

operational income before it is deducted by other nonoperational costs.

Earnings before interest and tax (EBIT), one of the commonly used to reflect the operational

Income instead of EBITDA. EBIT is usually used by most financial companies to measure the

ability of a company to pay the liabilities. Earning before tax (EBT) that is usually used to compare

with EBIT to measure the amount of Interest cost contributed to the net income.Net income, that is

the bottom line of income after it is deducted by all costs that enjoyed by the equity holders.


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The best category of profit that will be used in this research is net income. For net income is the

profit that is enjoyed by the equity holders, and it shows the ability of the company to give them

returns (Brigham and Houston, 2007).

In financial statements analysis of companies (non-financial) listed at Karachi stock exchange (2006-

2011) on page 15th Debt to equity ratio is define as a measure of companies financial leverage and

calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of

equity and debt the company is using to finance its assets. The higher ratio generally means that a

company has been aggressive in financing its growth with debt. This can result in volatile earnings

as a result of the additional interest expense.

Debt equity ratio = (Current Liabilities + Non-Current Liabilities)/ Shareholders equity

It provides a margin safety to creditors. The smaller the ratio, the more secured are the creditors. An

appropriate debt to equity ratio is 0.33. A higher ratio than this is an indication of financial risk

policy.

1.2 Problem Statement

The primary aim of the study is to know the impact of financial leverage on profitability of vehicles

companies in Pakistan.

1.3 Objective of the study

To study the influence of financial leverage on profitability of Vehicle companies in Pakistan.

1.4 Scope of the Research

For the study from Karachi stock exchange the non-manufacturing part is selected in which

we take all the registered Vehicle companies of Pakistan. The total registered vehicle

companies are 22.


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Chapter 2

LITERATURE REVIEW

2.1 LITERATURE REVIEW

Debt is used by many companies to leverage their capital and profit. However, debt is not the only

factors that effect to leverage capital and profit. There are several factors that can affect the

companies profitability. This research uses operational decision factor, macroeconomics factor, firm

size factor, and industry factors to help understand the effect of debt to profitability. Operational

decision factor is proxy by total assets turnover to explain how well the companies able to utilize

their assets to generate profit. Firm size factor is proxy by assets to measure the companies power to

generate profit. While macroeconomics factor is proxy by BI rate because it can represent the

inflation effect and the impact to the banks interest rate. The uniqueness of this research is to add

industry factor to compensate the other factors in determining the companies profitability. The

result indicates that in uncategorized (not categorized into different industries) data, debt, firm size,

and operational decision effect positively significant, and macroeconomics effect insignificantly

towards profitability. In addition, industry factor is found to affect companies profitability.

(Muhammad Shalahuddin Mustofa El-Wahid, 2011).

First, even if there turn on equity is high, a substantial financial leverage causes a great instability in

the net profit, i.e., on the volatility of dividends distributed per share. Therefore, the shareholder will

claim a premium to cover the risk. A high level of financial leverage allows shareholders to obtain a

high return on equity, but they are also exposed to a higher risk of significant loss if the return on

assets is low. Also, using loans may lead to restricting the independence of the companys

management, and creditors are interested in the indebtedness of the company. Financial leverage is


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combined with the operating leverage. The combined effect is equal to the product of the operating

and financial leverage (Nicoleta, 2010).

Asifand others (2010), investing the impact of financial leverage output profit of share land

profitable change on dividend policy the results of this research show the negative impact of

financial leverage on dividend policy. In other words, dividend decreases increasing the debts of

company and the profitable changes don't affect the dividend policy and profit output of shares

affects dividend policy positively.

Yoon, Eunju and Jang, Soo Cheong (2005), investing the impact of financial leverage and size of

the firm in the restaurant industry for period 1998 to 2003 using OLS regression his result

suggest that the firm size had more dominant effect on ROE of restaurant then debt use . Results

also suggest that regardless of having lower financial leverage, smaller restaurant firms were

significantly more risky than larger firms. As such, the dominance of size effect in the ROE-

financial leverage relationship within the restaurant industry is better understood.

The impact of operating leverage is evident, when a given percentage changes in net sales results in

a greater percentage change in operating income (EBIT). DOL and DFL combine to magnify a given

percentage change in sales to a potentially much greater percentage in EBIT. Operating and financial

leverages together cause wide fluctuation in EPS for a given change in sales. If a company employs

a high level of operating and financial leverage, even a small change in the level of sales, will have

dramatic effect on EPS.

A company with cyclical sales will have a fluctuating EPS, but the swings in EPS will be more

pronounced if the company also uses a high amount of operating and financial leverage. There is the

need to combine degree of operating and financial leverages to see the effect of total leverage on

EPS associated with a given change in turnover as a result of improved purchasing power enabled by


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capital structure (Ishola, 2008). First, even if the return on equity is high, a substantial financial

leverage causes a great instability in the net profit, i.e., on the volatility of dividends distributed per

share. Therefore, the shareholder will claim a premium to cover the risk. A high level of financial

leverage allows shareholders to obtain a high return on equity, but they are also exposed to a higher

risk of significant loss if the return on assets is low. Also, using loans may lead to restricting the

independence of the companys management, and creditors are interested in the indebtedness of the

company. Financial leverage is combined with the operating leverage. The combined effect is equal

to the product of the operating and financial leverage (Nicoleta, 2010).

The variables sales, interest, cash flow, asset structure, interest coverage, firms size, retained

earnings, earnings before interest and tax and intrinsic value of shares influence financial leverage

(Franklin and Muthusamy, 2011).

Most studies of capital structure used a basic assumption of the trade-off theory. Once firms find a

certain optimal combination of financing sources, that is, the mix of debt and equity sources that

balance the benefits of the tax shield provided by debt with the increased costs of financial distress

to the firms equity holders, firms should maintain this target capital structure. However, two

empirical studies indicated that this is not valid..(Myers, 2010).

The research question is that there is no significant influence of financial leverage on shareholders

return and market capitalization. The main objective of the research paper is to quantify the

influence of financial leverage on shareholders return and market capitalization. As it is well known

fact that financial leverage is one of the means by which shareholder return and market

capitalization can be improved, the effect of financial leverage can be utilized for stimulation of

shareholders return and market capitalization thereof.


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The basic purpose of using the financial leverage is to increase the shareholders return under

growing economic condition. The significance of financial leverage is inferred to increase the

shareholders return based on the assumption that the fixed charge can be easily recovered at lower

cost than the firms rate of return on net assets. Therefore, the difference between the earnings

generated by assets financed by the fixed charge fund and the cost of these funds is distributed to the

shareholders, as a result, the return on equity increases. However, the results of the study show that

financial leverage has no influence on the shareholders return of levered firms of automotive

industry. The probable reason might be that these companies have not found cheaper debt capital in

huge quantum than equity capital over the period of five years from 2006-2011).

The study also concludes that there might be other non-quantitative factors which may lead to nullify

the impact of financial leverage on shareholders return like recession, saturation of auto industry,

competition and government policy. It is important to note that financial leverage is a speculative

technique and there are special risks and costs involved with financial leverage. Indeed there can be

no assurance that a Financial Leverage strategy will be successful during any period in which it is

employed.

Cost of debt should be kept lower than cost of equity to get significant benefits of financial leverage.

Adequate equity capital is employed so as to increase borrowing capacity of the firm to get

significant influence of financial leverage.

However, this research failed to support the hypothesized positive relationship between financial

leverage and both profit measures. It was also hypothesized that highly leveraged restaurant firms

are riskier in terms of their return on equity and investment.

This study only used one independent variable, financial leverage, along with one covariate variable,

firm size. Because there are various factors affecting firms profitability and level of debt use besides


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these variables, in order to more effectively investigate the relationship between firms level of debt

use and their profitability and risk, inclusion of covariates besides the firm size is recommended for

future study.

That financial leverage has a negative impact on dividend policy, it means that companies with

higher leverage should divide less profit between shareholders. Operating cash flow has positive

impact on dividend policy it means. That by increasing the liquidity in company dividend pay out to

shareholders will increase. Size of company has positive impaction dividend policy. It means that

bigger companies can pay more profit.

According to the results of testing first hypothesis which showed the positive impact of financial

leverage on dividend policy we advise main shareholders of companies who have affective role in

dividend policy of company in anniversary of companies to consider seriously the debt ratio of

companies in other words if the debt ratio of company is high they should pay les profit also based

on results of second and third hypothesizes the relation between operating cash flow and size of

company is approved.

The research made by Listiadi (2007) on PT. Merck Tbk. annual report between 2003 and 2004

found that Total Assets turnover ratio have direct impact on ROE. This shows that operational

decisions have direct impact to companys profitability.

Firm size shows the value of assets of the company. When a company has more assets than the other

similar companies it not only indicates that it is larger than the other companies but it has also better

production abilities. When a company has better production capability than the other, then it has

potential to generate more profit better than other related company. However, at a certain amount of

assets, the productivity will might reach its maximum to meet the demand.


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Debt is used in many companies to leverage its financial performance. The companies increase its

financial performance by using debt to finance assets. The increase in companies assets is expected

to increase the net income. The increase in net income will impact on the increase of return on

equity. Therefore, the equity holder expected that by using more debt, it will increase the return on

equity (Brigham & Houston, 2007).

Total assets turnover indicates efficient utilization of assets. It is measured by dividing sales with

total assets. Total assets turnover shows performance of management based on the amount of sales

that they can produce by investing in assets.

Total Assets Turnover = Total Sales / Total Assets

2.2 Theoretical framework

2.3 Hypothesis

H0: There is no significant impact of financial leverage on profitability

H1: There is significant impact of financial leverage on profitability

Financial Leverage Profitability


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CHAPTER 3

RESEARCH METHODOLOGY

3.1 Type of Data

The Panel data is used for the purpose of research

3.1.1 Period of Study

The study covered Six years time period from 2006 to 2011.

3.1.2 Statistical Tools

Statistical Tools Used for the Analysis of Research is SPSS (Statistical Package for the Social

Sciences) in which we will run regression Analysis in regression analysis we will use the simple

regression model

3.1.3 Source of Data:

Data is secondary and collected from different sources Websites and Articles

3.2 Population

The population of the study includes the Vehicle companies of Pakistan

3.2.1 Samples

The samples are the non-financial companies from 2006 to 2011, and there were 22 existing

companies that listed in Karachi Stock Exchange. The result shows that there are 22 companies such

as follows:


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3.2.2 Variables:

a) Dependent Variable: The dependent variable is Profitability.

b) Independent Variables: The independent variable is financial leverage.

Independent Variable Dependent Variable

3.3 The Regression Equation

From the profitability function described above, it can be put into equation as follows:

Profitability = f (Financial Leverage) (General form)

ROE = 0 + FL + (Linear form)

0 stand for constant of regression

1 coefficient of financial leverage

stand for error term.

ProfitabilityFinancial Leverage


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Chapter 4

RESULTS AND ANALYSIS

4.1 RESULTS

Model Summary

Model R R Square

Adjusted R

Square

Std. Error of

the Estimate Durbin-Watson

1 .101a

.010 .002 58.98236 1.450

a. Predictors: (Constant), DebtEquity

b. Dependent Variable: ROE

ANOVA

Model

Sum of

Squares df Mean Square F Sig.

1 Regression 4617.687 1 4617.687 1.327 .251a

Residual 452259.369 130 3478.918

Total 456877.057 131

a. Predictors: (Constant), DebtEquity

b. Dependent Variable: ROE


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Coefficientsa

Model

Unstandardized

Coefficients

Standardized

Coefficients

t Sig.B Std. Error Beta

1 (Constant) 21.349 5.305 4.024 .000

DebtEquity 2.447 2.124 .101 1.152 .251

a. Dependent Variable: ROE

4.2 Analysis

Specification of the Model:

Profitability = f (Financial Leverage) (General form)

ROE = 0 + DTE+ (Linear form)

Estimation of the Regression Model

ROE = 21.349 + 2.447 DTE

Diagnostic Statistics

(5.305) (2.124) (Standard error)

(4.024) (1.152) (t-statistic)

(0.000) (.251) (p-value/sig. level)

R= .101 R2

= .010 R2

adjusted = .002

F = 1.327 (p-value = .251) DW = 1.450 N = 132


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4.3 Evaluation of the Model Using Diagnostics Statistics

The value of R (Correlation) shows the relationship between dependent variable and independent

variable here the dependent variable is return on equity while the independent variable is debt to

equity ratio here the standard value for R should be more than 90% but here its value is 10.1% which

shows there is a very minor relation between dependent variable (ROE) and independent variable

(Debt to Equity).

The Coefficient of determination R2

show that how much variation in dependent variable is

explaining by variance due to in independent variable. Here the value of R2

is just 1% which show a

very little variation in dependent variable (Return on equity) due to independent variable (Debt to

equity.

F-Statistics shows the fitness of the model while P-Value show whether it is significant of

insignificant. For highly significant the value must have to be 1% , for moderate significant the value

must be above 1% and equal or less than 5%, for significant the value must above 5% and equal or

less than 10% the value above then 10% considered as insignificant. Here the value of P-Value is

25% which means the relation between independent variable (debt to equity) and dependent variable

(Return on equity) is insignificant so we are accepting the null hypothesis while rejecting the

alternative hypothesis.

F-Statistics

The value of show the change brings in dependent variable due to independent variablewhile

shows the slandered error. Here the value of shows that 1% of Debt bring change 2.447% of

change in return on equity but the value of P shows the insignificant impact in between dependent

and independent variable.

Interpretation of the model

The value of shows that 1% of Debt willbring change 2.447% in Return on equity.


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Chapter 5

DISCUSSION, CONCLUSION,

RECOMMENDATIONS AND LIMITATIONS

5.1 Discussion

Here we are accepting the Null hypotheses H0: There is no significant impact of financial leverage

onprofitability while the other researchers from the past show the positive impact on profitability

with other variables as according to (Muhammad Shalahuddin Mustofa El-Wahid, 2011) show the

significant effect of data, debt, firm size, and operational decision on profitability

Here we are considering the macroeconomic factor (financial leverage) which shows the

insignificant effect on profitability

The type of company is the major factor considering for the significant and Non-significant impact

of financial leverage on profitability according to

In 2005 Yoon, Eunju and Jang, Soo Cheong investigated that the firm size had more dominant effect

then financial leverage so here our result is insignificant because we are taking just financial

leverage while the effect of firm size on profitability is more than the financial leverage.

The type of company is another factor which shows the positive and negative relation of financial

leverage on profitability from the recent research of Niaz, 2013. Conducted the same research on

cemment companies in which his result the financial leverage had significant impact on profitability.

Our selected companies are not that much high leverage companies so that is why our result is

insignificant.

The research made by Listiadi (2007) on PT. Merck Tbk. annual report between 2003 and

2004 found that Total Assets turnover ratio have direct impact on ROE. This shows that operational


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decisions have direct impact to companys profitability. In the research of Listiadi the result is

significant by taking the operational decisions as independent variable.

5.2 Conclusion

The research was conducted to know the impact of financial leverage on Profitability of Non-

financial sector of stock exchange. 22 registered vehicle companies were taken for the purpose of

study from Karachi stock exchange. In this research one affective factor Financial Leverage on

profitability has been investigated on the basis of findings achieved by research and testing the

hypothesis the result indicate that there is in significant impact of financial leverage on profitability

5.3 Limitations

1) BBA level having no such information and command on using SPSS and other models2) Time frame

5.4 Recommendations

1) There are also other variables which effect Profitability Positively or Negatively so need towork on them .These variables are as follow

a) Dividend Policyb) Uncertainty Financial Riskc) Government Policyd) Cheaper Debt Capitale) Expected Returnf) Optimal Amountg) Lossh) Taxi) Recession

j) Investment Decisionk) Interestl) Less Rate of Return on Equity


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References

1) Asif,Aasia, Rasool,Waqas,Kamal. & Yasir.(2010). Impact of Financial Leverage onDividend.

2) Brigham, Eugene F., and Joel F. Houston. (2007). Essentials of Financial Management. Cengage Learning Asia Pte Ltd, Singapore.

3) 138European Journal of Economics, Finance and Administrative Sciences - Issue 32 (2011)4) Kim, W. (1997). The determinants of capital structure choice in the US restaurant industry.

Tourism Economics, 3, 329-340.

5) Listiadi, Agung. Financial Analysis of Du Pont System as Profitability Measurement.6) Yoon, E., and Jang, S, C. (2005) "The Effect of Financial Leverage on Profitability and Risk

of Restaurant Firms," Journal of Hospitality Financial Management: Vol. 13: Iss. 1,Article

24.

7) Nicoleta.,&Brbu-Miu (2010). Financial Risk Analysis in the Building Sector: A CaseStudy of Romania (Galati County). ISSN 1392-1258. EKoNoM IKA. 89(1). Department of

Finance and Economic Efficiency, Dunrea de Jos University of Galati, Domneasca Street

No. 47, Galati, 800008 Romania; e-mail: [email protected]. Dunrea de Jos

University of Galati, Romania.

8) Policy: Empirical Evidence from Karachi Stock Exchange-Listed Companies AfricanJournal of Business Management, Vol. 5(4), pp. 1312-1324.


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Appendix 1

1. PT. Agriauto Industries Ltd.

2. PT. Al-Ghazi Tractors Ltd.

3. PT. Atlas Battery Ltd.

4. PT. Atlas Engineering Ltd.

5. PT. Atlas Honda Ltd.

6. PT. Baluchistan Wheels Ltd.

7. PT. Bela Automotive Ltd.

8. PT. Bolan Castings Ltd.

9. PT. DewanAuto.Eng. Ltd.(Allied

Motors Ltd.)

10.PT. DewanFarooque Motors Ltd.11.PT. Exide Pakistan Ltd.*****12.PT. General Tyre& Rubber Co.

Ltd.

13.PT. Industries Ltd.14.PT. Ghandhara Nissan Ltd.15.PT. Ghani Automobiles

Industries Ltd.

16.PT. Hinopak Motors Ltd.*****17.PT. Honda Atlas Cars (Pakistan)

Ltd.*****

18.PT. Indus Motor Company Ltd.


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19.PT. Millat Tractors Ltd.20.PT. Pak Suzuki Motor Company

Ltd.**

21.PT. Sazgar Engineering WorksLtd.

22.PT. Transmission EngineeringInds. Ltd.

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The Impact of Financial Leverage to Profitability Study of Vehicle Companies From Pakistan (2)(1) (1)